Small Business Questions & Answers

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Ask About Credit Default Swaps and the Credit Crunch

by Swap Shy in Sacramento | October 28, 2011

Subject :Finances

Dear Toolkit,

My boss just stopped by my desk to borrow some Excedrin and he was muttering something about how we'll all be ruined by credit default swaps. Should I be doing something to prepare for this like getting vaccinated or building an underground shelter? What are these dreaded credit default swaps anyway?

Thanks,

Swap Shy in Sacramento

Dear Swap Shy,

Although I had decided to avoid addressing our global financial meltdown until the final autopsy results are in, I'll make an exception for you in this case. Credit default swaps (CDS) are a type of that mysterious class of creatures called "derivatives." Derivatives include options, futures, forwards and swaps, traded by people and institutions, many of whom evidently don't understand their complexities; hence they have become one of the prime suspects in the current banking crisis.

Credit default swaps are contracts designed to work like insurance policies of sorts. Let's say you are an investment bank and you bought a "securitized" mortgage loan bundle. You're pretty sure it's OK and will make money for your investors, but just to be sure, you want some protection against any unknown downside risk of loan defaults. So you go to the seller or a bond insurer (the issuer bank or Ambac, et. al.) and pay him a big chunk of cash every month so if anything goes wrong he'll cover your losses.

The insurance premiums you pay for the credit default swap's protection are all plus revenue for the seller. He doesn't have to do anything to earn it. He's not regulated like a real insurance company. He's not required to maintain reserves, adhere to any statutes or undergo periodic examinations. He's not even required to show this contingent liability on his balance sheet. CDSs are unregulated individual bets between financial institutions. The seller bets the securities you bought are good and you, by buying protection, bet they may not be. Or, in an even more ridiculous example, you don't even have to hold or have held the underlying security to sell or buy these "protection contracts."

Hedge funds deal in this stuff all day long. If someone wants to bet them a security might default, who are they to decline to collect all those juicy premiums? This is the so-called free market at its worst or best, depending on which side of the trade you're on, of course. If the security does belly up and the insurer has no cash to pay off the CDS, it's like the song by ABBA. . . "Somebody was lying, now somebody is crying."

In the current crisis, it would seem as though many underlying securities are deemed "toxic." But worse yet, the CDSs you bought may also be no good since their sellers have inadequate reserves to pay you for your losses. And what's really scary is that the Bank for International Settlements stated, as long ago as December 2007, that overall "derivative" trades (including CDSs) totaled over $680 trillion at that time. To put this enormous number into context, it is said to be 10 times the gross domestic product of all the world's countries combined.

CDSs have only been around for about a decade and most have a term of 5 years. They are the most-utilized instruments to mitigate risk in bond investing and are good for short positioning without requiring immediate cash outlays. They're also a good portfolio management tool. It's only when they are misused and abused that devastating results can arise. Many of their problems are caused by a total lack of transparency, the normal result of a total lack of regulation (this hands-off, no-reg policy was dictated by former Fed chief Alan Greenspan). Opaque vehicles such as CDSs were always traded on "trust" between banks, a kind of insider's gentleman's agreement and mutual reliance.

Credit default swaps are merely one drop in a sea of complicated banking vehicles that have obscured monetary systems for decades. The root problem with the global economy now seems, however, to have less to do with the mechanics of trading than the distrust among the banks of the world.

To put this in more understandable terms, let's use a simple example. You head over to McDonald's drive-through lane to pick up lunch as you have each noon for years. You order your Big Mac, large fries and Coke through the speaker by the menu board. The order taker says "that'll be $7.25 please" and tells you to pull up to the first window. You do, and the cashier tells you to give her $7.25 and then pull up to a second window to get your food. You say "hey, wait a minute….how do I know they'll actually give me my whole order at the next window? I'm not paying you till I get my Big Mac and fries in my hand." The cashier shrugs her shoulders and tells you to move on, you're holding up traffic. The lady at the food pickup window refuses to give you the food without a receipt or take the money from you, declaring that she's not the cashier. "Move along, you're holding up traffic."

If the whole world follows this same behavior pattern, nobody will get lunch. After a few days of this, the food in inventory at that store will rot. They can't order more since they have no cash. And they can't pay employees for the same reason. So 30 people are laid off, the store closes, their suppliers have to lay people off and so on down the chain. All because you didn't trust the normal procedures of the fast food drive-in business that you've used successfully for years.

We'll all observe with cautious interest how this scene plays out over the next weeks and months. Will governments put their full faith and credit behind the suddenly timid and, in some cases, insolvent banks and guarantee their transactions can be trusted? Does the power to levy taxes make governments more trustworthy than banks?